Kinross Pays a Golden Premium

In fact, for aspiring chic geeks who view Apple's gadgets as status symbols, there's actually a $187,000 blinged-out version of the iPad, plated in 22-carat gold and encrusted with diamonds.

But for Fools like me, who view gold as a practical means of protection from the fiscal consequences of reflationary responses to the ongoing financial crisis, keeping a low cost basis for gold holdings remains a key priority for maximizing returns.

Consummate consolidator Kinross Gold (NYSE: KGC) must now convince cost-conscious investors that the company is not paying too high a premium for its supply of the shiny yellow stuff.

The lofty price tag
On Monday, Kinross announced a friendly merger to acquire the shares of Red Back Mining, in exchange for Kinross shares and purchase warrants valued at $7.1 billion. Since Kinross already owns 9.3% of Red Back shares, the deal implies a $7.83 billion valuation for a producer with 8.07 million ounces of proven and probable gold reserves. Even if we back out Red Back's $730 million cash hoard, the valuation amounts to $880 for each gold ounce in reserves; which is $132 more (per ounce) than Barrick Gold's (NYSE: ABX) second-quarter operating margin.

Of course, one expects to pay up for two fully operational and profitable gold mines near the beginning of their productive life cycle. Kinross scored a terrific bargain when it acquired the Lobo-Marte project in Chile from Teck Resources (NYSE: TCK) and Anglo American for $42 per ounce-in-reserves. But with no mine on the site, that deal is utterly incomparable. For a more reasonable comparison, we can look to the pending acquisition of Lihir Gold (Nasdaq: LIHR) by Australian giant Newcrest Mining.

Lihir's board has blessed Newcrest's revised offer of nearly $8.7 billion, and that deal now appears set to proceed. Using the same procedure as above, the valuation that Newcrest's offer places upon Lihir is equivalent to $265 per ounce of gold in reserves. Expressed another way, the implied valuation of Lihir's non-cash assets is just 15% more than the Red Back valuation, but Lihir offers 284% more proven and probable gold reserves than Red Back. Moreover, with more than 1 million ounces of annual production, Lihir's existing production volume is more than twice that of Red Back.

The crucial caveats
Although it may appear at a glance that Kinross is paying an exorbitant sum for this producer with mines in two West African nations, the transaction is set at only a 21% premium to the pre-announcement share price. Clearly, Red Back shareholders see value in this company beyond its existing reserve base. As an existing stakeholder, furthermore, Kinross already possessed an insider's view of the company's true potential. There is a consensus perception of value here that is perhaps not immediately apparent to the casual observer.

With myriad factors to consider, from ore grades to recovery rates, direct comparisons (like the one with Lihir Gold above) are seldom seamless. However, a $615 per-ounce-in-reserve disparity in implied valuation between two established producers can, in my opinion, only be ascribed to a confident expectation of massive reserve expansion.

According to Kinross, "The significant upside in reserves that we believe exists at Red Back, and Kinross' ability to accelerate that potential, makes this an outstanding prospect for shareholders of both companies."

This reminds me of Goldcorp's (NYSE: GG) similarly bullish characterization of the San Dimas mine sold to soon-to-launch Primero Mining, where Goldcorp stated: "the true potential of the deposits are neither fully realized nor reflected in the stated reserves and resources."

That's the nature of this industry: The greatest buried treasures are often the ones that have not been precisely quantified. To become a very skilled investor in this sector, one almost needs to become an amateur geologist, capable of interpreting drilling assays and extrapolating insights into complex vein structures.

With a remarkable exploration effort under way, employing 26 drilling rigs between the two mine complexes, I suspect that Kinross has pounced upon this emerging treasure in advance of a wholesale reserve expansion that will justify the expenditure over time. I expect this transaction to spark further acceleration of dealmaking activity in the sector, with cash-flush giants like Newmont Mining (NYSE: NEM) likewise being forced to pony up a pretty penny for assets in production. As for Kinross, the gap that I had identified in its production pipeline has finally been filled in. Kinross has graduated from a miner to avoid to a miner worth watching.